On Thursday the European Central Bank announced that it was setting their interest rate at -0.1%. This is not a typo, it is a negative interest rate. It applies to all 18 countries in the Eurozone, and the rest of the developed world will be watching what happens – as it is the first time this has been done on such a scale. But what does ‘negative interest rates’ mean?

To explain, it’s important to explain how a central bank works. Every bank within the Eurozone has to keep some reserves of money in the ECB so that daily withdrawals can be met. They can also keep some reserves in the ECB to earn interest. If they are doing that – it means that money isn’t being used for lending to individuals and businesses.

That lending is needed to give much needed stimulus to the Eurozone economies. Businesses and individuals will borrow money and spend it – increasing their consumption in some cases, and investment in others, which helps the economy grow in both the short and long term. There is a useful ‘multiplier’ effect that can ensue, with the money lent used for spending, which creates jobs to meet that demand, which puts more money in peoples’ pockets to spend, and so on. Or the money is used to create jobs, which leads to more spending etc etc. The ECB’s policy is effectively trying to inject money into what is called the ‘circular flow of income’.

Given that the Eurozone is at the moment afflicted by a large amount of unemployment, very slow growth, and very low inflation, there is some need for that stimulus. Individual countries in the Eurozone still have control over fiscal policy, but most of them are running budget deficits at the moment (spending is greater than tax receipts), so don’t have money spare to perform that stimulus themselves.

So the ECB, which only has control of monetary policy, has to choose between using quantitative easing  (QE – ‘printing money’ in computerized form, giving it to banks in the hope they will lend) and lowering interest rates that are already close to zero (so supposedly had nowhere to go). QE has been effective up to a point, but many have commented that it doesn’t force banks to lend that money, and some banks may instead have built up their reserves, paid higher bonuses, and essentially not used that printed money for the purpose the ECB have intended. Hence negative interest rates.

Negative interest rates mean that banks have to ‘pay’ to keep their reserves in the ECB. What should happen is that instead of trying to earn profit by keeping excess reserves in the ECB and earning interest that way, banks will try and earn profit by lending to businesses and individuals – with the resulting multiplier effect explained above.

Of course, negative interest rates could actually lead to a variety of outcomes. They MAY lend more. OR they could start charging consumers more to keep money in their bank accounts, making profits that way. They MAY do nothing, just eating the loss they are making so they don’t alienate customers. OR they could pass the negative interest rate onto their own customers – this could make customers withdraw money from their accounts, which might mean those customers spend more or invest elsewhere.

The most optimistic scenario, and arguably the most effective one, is that the banks will be encouraged to lend more money to businesses, who will expand, create jobs, and properly kickstart the multiplier process that will lead to economic growth and lower unemployment.

The policy has been tried before in Denmark, where in 2012 the central bank set an interest rate of -0.2. Results from that have been inconclusive, with no evidence it affected lending or spending. However, the ECB is bigger, and covers a lot of countries. So it will be very interesting to watch this space.